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Risk Management and Financial Institutions by John Hull

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Risk Management and Financial Institutions by John Hull Powered By Docstoc
					                  SECOND                EDITION


   RISK MANAGEMENT
         AND
FINANCIAL INSTITUTIONS
                              John C. Hull
   Maple Financial Group Professor of Derivatives and Risk Management
                Joseph L. Rotman School of Management
                        ' University of Toronto




       Boston Columbus Indianapolis New York San Francisco Upper Saddle River
Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto
  Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo
                                                                   Contents
           Business Snapshots                                             xiii
           Preface                                                         xv
Chapter 1. Introduction                                                     1
           1.1    Risk vs. return for investors                             2
           1.2    The efficient frontier                                    5
           1.3    The capital asset pricing model                           7
           1.4    Arbitrage pricing theory                                 12
           1.5    Risk vs return for companies                             12
           1.6    Risk management by financial institutions                14
                  Summary                                                  16
                  Further reading                                          17
                  Practice questions and problems                          17
                  Further questions                                        18
Chapter 2. Banks                                                           19
           2.1    Commercial banking                                       20
           2.2    The capital requirements of a small commercial bank      22
           2.3    Deposit insurance                                        24
           2.4    Investment banking                                       25
           2.5    Securities trading                                       29
           2.6    Potential conflicts of interest in banking               30
           2.7    Today's large banks                                      31
           2.8    The risks facing banks                                   34
                  Summary                                                  35
                  Further reading                                          36
                  Practice questions and problems                          36
                  Further questions                                        37
Chapter 3. Insurance Companies and Pension Plans                           39
           3.1    Life insurance                                           39
           3.2    Annuity contracts                                        43
           3.3    Mortality tables                                         45
           3.4    Longevity and mortality risk                             47
           3.5    Property-casualty insurance                              48
           3.6    Health insurance                                         50
           3.7    Moral hazard and adverse selection                       52
           3.8    Reinsurance                                              53
           3.9    Capital requirements                                     53
           3.10 The risks facing insurance companies                       54
           3.11 Regulation                                                 55
           3.12 Pension plans                                              56
                  Summary                                                  59

                                                                          vii
Vlll                                                              Contents

                    Further reading                                     60
                    Practice questions and problems                     60
                    Further questions                                   61
Chapter 4.   Mutual Funds and Hedge Funds                               63
             4.1    Mutual funds                                        63
             4.2    Hedge funds                                         70
             4.3    Hedge fund strategies                               74
             4.4    Hedge fund returns                                  78
                    Summary                                             80
                    Further reading                                     80
                    Practice questions and problems                     81
                    Further questions                                   81
Chapter 5.   Financial Instruments                                      83
             5.1    The markets                                         83
             5.2    Long and short positions in assets                  84
             5.3    Derivatives markets                                 86
             5.4    Plain vanilla derivatives                           87
             5.5    Margins                                             97
             5.6    Nontraditional derivatives                         101
             5.7    Exotic options and structured products             104
             5.8    Risk management challenges               .,        105
                    Summary                                            106
                    Further reading                                    107
                    Practice questions and problems                    108
                    Further questions                                  110
Chapter 6.   How Traders Manage Their Exposures                        113
             6.1    Delta                                              113
             6.2    Gamma                                              120
             6.3    Vega                                               122
             6.4    Theta                                              124
             6.5    Rho                                                124
             6.6    Calculating Greek letters                          125
             6.7    Taylor series expansions                           126
             6.8    The realities of hedging                           128
             6.9    Hedging exotic options                             129
             6.10 Scenario analysis                                    130
                     Summary                                           131
                    Further reading                                    131
                    Practice questions and problems                    131
                     Further questions                                 133
Chapter 7.   Interest Rate Risk                                        135
             7.1    The management of net interest income              135
             7.2     LIBOR and swap rates                              138
             7.3     Duration                                          139
             7.4     Convexity                                         142
             7.5     Generalization                                    144
             7.6    Nonparallel yield curve shifts                     146
             7.7     Interest rate deltas in practice                  148
             7.8     Principal components analysis                     150
             7.9     Gamma and vega                                    153
                     Summary                                           154
Contents                                                                             ix

                      Further reading                                               154
                      Practice questions and problems                               155
                      Further questions                                             155
Chapter 8.    Value at Risk                                                         157
              8.1     Definition of VaR                                             157
              8.2     Examples of the calculation of VaR                            158
              8.3     VaR vs expected shortfall                                     160
              8.4     VaR and capital                                               162
              8.5     Coherent risk measures                                        163
              8.6     Choice of parameters for VaR                                  165
              8.7     Marginal VaR, incremental VaR, and component VaR              168
              8.8     Back-testing                                                  169
                      Summary                                                       172
                      Further reading                                               172
                      Practice questions and problems                               173
                      Further questions                                             174
Chapter 9.    Volatility                                                            175
              9.1     Definition of volatility                                      175
              9.2     Implied volatilities                                          177
              9.3     Estimating volatility from historical data                    179
              9.4     Are daily percentage changes in financial variables normal?   180
              9.5     Monitoring daily volatility                                   184
              9.6     The exponentially weighted moving average model               186
              9.7     The GARCH(1,1) model                                          188
              9.8     Choosing between the models                                   189
              9.9     Maximum-likelihood methods                                    190
              9.10 Using GARCH(1,1) to forecast future volatility                   194
                      Summary                                                       197
                      Further reading                                               198
                      Practice questions and problems                               199
                      Further questions                                             200
Chapter 10.   Correlations and Copulas                                              203
              10.1 Definition of correlation                                        203
              10.2 Monitoring correlation                                           205
              10.3 Multivariate normal distributions                                208
              10.4 Copulas                                                          210
              10.5 Application to loan portfolios                                   216
                      Summary                                                       218
                      Further reading                                               218
                      Practice questions and problems                               219
                      Further questions                                             220
Chapter 11.   Regulation, Basel II, and Solvency II                                 221
              11.1 Reasons for regulating banks                                     221
              11.2 Bank regulation pre-1988                                         222
              11.3 The 1988 Basel accord                                            223
              11.4 The G-30 policy recommendations                                  226
              11.5 Netting                                                          227
              11.6 The 1996 amendment                                               229
              11.7 Basel II                                                         231
              11.8 Credit risk capital under Basel II                               232
              11.9 Operational risk capital under Basel II                          240
x                                                                          Contents

              11.10  Pillar 2: supervisory review                              240
              11.11  Pillar 3: market discipline                               241
              11.12  Revisions to Basel II                                     241
              11.13  Solvency II                                               243
                     Summary                                                   244
                     Further reading                                           245
                     Practice questions and problems                           245
                     Further questions                                         247
Chapter 12.   Market Risk VaR: Historical Simulation Approach                  249
              12.1 The methodology                                             249
              12.2 Accuracy                                                    254
              12.3 Extensions                                                  255
              12.4 Extreme value theory                                        259
              12.5 Applications                                                261
                     Summary                                                   263
                     Further reading                                           264
                     Practice questions and problems                           264
                     Further questions                                         265
Chapter 13.   Market Risk VaR: Model-Building Approach                         267
              13.1 The basic methodology                                       267
              13.2 Generalization                                              269
              13.3 Correlation and covariance matrices                         270
              13.4 Handling interest rates                                     274
              13.5 Applications of the linear model                            277
              13.6 Linear model and options                                    277
              13.7 Quadratic model                                             280
              13.8 Monte Carlo simulation                                      282
              13.9 Nonnormal distributions                                     283
              13.10 Model building vs historical simulation                    284
                     Summary                                                   285
                     Further reading                                           285
                     Practice questions and problems                           285
                     Further questions                                         287
Chapter 14.   Credit Risk: Estimating Default Probabilities                    289
              14.1 Credit ratings                                              289
              14.2 Historical default probabilities                            291
              14.3 Recovery rates                                              293
              14.4 Credit default swaps                                        294
              14.5 Credit spreads                                              298
              14.6 Estimating default probabilities from credit spreads        301
              14.7 Comparison of default probability estimates                 303
              14.8 Using equity prices to estimate default probabilities       307
                     Summary                                                   309
                     Further reading                                           310
                     Practice questions and problems                           310
                     Further questions                                         312
Chapter 15.   Credit Risk Losses and Credit VaR                                313
              15.1 Estimating credit losses                                    313
              15.2 Credit risk mitigation                                      319
              15.3 Credit VaR                                                  321
              15.4 Vasicek's model and Merton's model                          323
Contents                                                                xi

              15.5   Credit Risk Plus                                  324
              15.6   CreditMetrics                                     325
                     Summary                                           329
                     Further reading                                   329
                     Practice questions and problems                   330
                     Further questions                                 331
Chapter 16.   ABSs, CDOs, and the Credit Crunch of 2007                333
              16.1 The US housing market                               333
              16.2 Securitization                                      336
              16.3 Valuation mistakes                                  341
              16.4 Avoiding future crises                              342
              16.5 Synthetic CDOs                                      346
                     Summary                                           348
                     Further reading                                   349
                     Practice questions and problems                   350
                     Further questions                                 350
Chapter 17.   Scenario Analysis and Stress Testing                     353
              17.1 Generating the scenarios                            353
              17.2 Regulation                                          358
              17.3 What to do with the results                         361
                     Summary                                           364
                     Further reading                                   364
                     Practice questions and problems                   365
                     Further questions                                 365
Chapter 18.   Operational Risk                                         367
              18.1 What is operational risk?                           368
              18.2 Determination of regulatory capital                 369
              18.3 Categorization of operational risks                 371
              18.4 Loss severity and loss frequency                    371
              18.5 Proactive approaches                                375
              18.6 Allocation of operational risk capital              377
              18.7 Use of the power law                                378
              18.8 Insurance                                           378
              18.9 Sarbanes-Oxley                                      379
                     Summary                                           380
                     Further reading                                   381
                     Practice questions and problems                   381
                     Further questions                                 382
Chapter 19.   Liquidity Risk                                           385
              19.1 Liquidity trading risk                              385
              19.2 Liquidity funding risk                              391
              19.3 Liquidity black holes                               398
                     Summary                                           403
                     Further reading                                   404
                     Practice questions and problems                   405
                     Further questions                                 405
Chapter 20.   Model Risk                                               407
              20.1 Marking to market                                   407
              20.2 Models for linear products                          409
              20.3 Physics vs.                            finance      410
              20.4 How models are used for pricing standard products   411
xii                                                                   Contents

            20.5  Hedging                                                 418
            20.6  Models for nonstandard products                         418
            20.7  Dangers in model building                               419
            20.8  Detecting model problems                                420
                  Summary                                                 421
                  Further reading                                         421
                  Practice questions and problems                         422
                  Further questions                                       422
Chapter 21. Economic Capital and RAROC                                    425
            21.1 Definition of economic capital                           425
            21.2 Components of economic capital                           427
            21.3 Shapes of the loss distributions                         429
            21.4 Relative importance of                       risks       430
            21.5 Aggregating economic capital                             432
            21.6 Allocation of economic capital                           435
            21.7 Deutsche bank's economic capital                         436
            21.8 RAROC                                                    436
                  Summary                                                 438
                  Further reading                                         439
                  Practice questions and problems                         439
                  Further questions                                       440
Chapter 22. Risk Management Mistakes to Avoid                             441
            22.1 Risk limits                                              441
            22.2 Managing the trading room                                444
            23.3 Liquidity risk                                           446
            22.4 Lessons for nonfinancial corporations                    448
                  Summary                                                 450
                  Further reading                                         450
Appendix A: Compounding Frequencies and Interest Rates                     451
Appendix B: Zero Rates, Forward Rates, and Zero-Coupon Yield Curves        455
Appendix C: Valuing Forward and Futures Contracts                          459
Appendix D: Valuing Swaps                                                  461
Appendix E: Valuing European Options                                       463
Appendix F: Valuing American Options                                       465
Appendix G: Taylor Series Expansions                                       469
Appendix H: Eigenvectors and Eigenvalues                                   473
Appendix I: Principal Components Analysis                                  475
Appendix J: Manipulation of Credit Transition Matrices                     477
Answers to Practice Questions and Problems                                 479
Glossary of Terms                                                          511
DerivaGem Software                                                         533
Tables for Cumulative Normal Distribution                                  539
Index                                                                      543
                           BUSINESS SNAPSHOTS

 1.1   The Hidden Costs of Bankruptcy                            14
 2.1   Google®'sIPO                                              28
 2.2   Peoplesoft's Poison Pill                                  29
 2.3   How to Keep Loans Performing                              33
 3.1   Equitable Life                                            44
 3.2   A Perfect Storm                                           58
 4.1   Mutual Fund Returns Can Be Misleading                     69
 5.1   The Unanticipated Delivery of a Futures Contract          90
 5.2   A System's Error                                          91
 5.3   Microsoft®'s Hedging                                     105
 5.4   Procter and Gamble's Bizarre Deal                        106
 5.5   The Barings Bank Disaster                                107
 6.1   Hedging by Gold Mining Companies                         116
 6.2   Dynamic Hedging in Practice                              128
 6.3   Is Delta Hedging Easier or More Difficult for Exotics    130
 7.1   Expensive Failures of Financial Institutions in the US   137
 8.1   Historical Perspectives on VaR                           158
 9.1   What Causes Volatility?                                  177
 9.2   Making Money from Foreign Currency Options               182
11.1   Systemic Risk                                            222
11.2   Basel III?                                               242
14.1   The CDS Market                                           295
14.2   Is the CDS Market a Fair Game?                           296
14.3   Risk-Neutral Valuation                                   305
15.1   Long-Term Capital Management's Big Loss                  321
15.2   Downgrade Triggers and Enron's Bankruptcy                322
16.1   Not All BBBs Are the Same                                342
17.1   Traffic Light Options                                    361
18.1   The Hammersmith and Fulham Story                         376
18.2   Rogue Trader Insurance                                   380
19.1   Northern Rock                                            392
19.2   Ashanti Goldfields                                       395
19.3   Metallgesellschaft                                       396
19.4   The Crash of 1987                                        400
20.1   Kidder Peabody's Embarrassing Mistake                    410
20.2   Exploiting the Weaknesses of a Competitor's Model        411
20.3   Crashophobia                                             415
21.1   The EGTFund                                              432
22.1   Big Losses                                               442

				
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